The Mystery of the Government Windfall

June 6, 2012 By The Mad Hedge Fund Trader

I heard a fascinating story from my friends at the US Treasury the other day. Even though unemployment is high, personal tax refunds were plummeting and tax revenues were soaring. What was even more puzzling was that the states with the worst unemployment rates, like California, Nevada, and Florida were seeing the heftiest increases. Weren’t elevated jobless rates supposed to generate less taxable income, not more?

The intrepid sleuths on Pennsylvania Avenue put some financial detectives on the case to solve the mystery. It turns out that with home ownership rates falling, real estate prices doing a swan dive, and interest rates at 200 year lows, taxpayers are losing their largest deductions, causing the tax bills to rocket. During the 2011 tax year deductions fell by some 20%, an enormous move given that there were no serious tax reforms enacted.

It turns out that this has been going on for some years, thanks to the unremitting bull market in bonds. According to IRS data, the home mortgage deduction, which can be worth up to $26,000 per household, fell by 14% from 2007 to 2009. The total number of returns claiming this deduction dropped by 5 million during these years.

Preliminary data show that this write off dropped by another 7.2% in 2010 alone. The windfall could bring in as much as $26 billion in additional federal revenues in 2012. It not just a payday for Washington. The 42 states with income taxes are seeing similar revenue rises, with California by far the biggest beneficiary, where the number of filers claiming a home mortgage deduction declined by 9% in 2011.

What’s more, the gravy train for government green eye shades could speed up from here. If the Federal Reserve modifies and extends its “twist” policy of monetary easing through the purchase of mortgage securities, interest rates could crater as much as 25% from here. Tax bills would soar accordingly. Budget constrained governments across the country couldn’t be happier.

The home mortgage deduction has been a sacred cow of American politics since it was first initiated in 1913. Whoever though it would self-destruct?

Yes, That is Definitely a Smaller Deduction

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